The surprise in the markets last week wasn’t that they rallied after three days of triple-digit losses in the Dow Jones. Equities were oversold, bonds were overbought and investor sentiment was ripe for the picking. Prices were likely to start reversing in the back half, as we wrote last week, for both calendar and technical reasons.

Certainly the magnitude of the move caught many wrong-footed. The juice factor was once again news from Europe, with the most recent dose being European Central Bank (ECB) chairman Mario Draghi’s declaration that the ECB would do whatever was required to keep the euro intact (“and believe me, it will be enough”).

Looked at from a distance, the fact that a central banker claims he can and will do whatever is necessary to save a currency is not exactly revolutionary. Not only is it a standard assertion in the banker toolkit, the irony is that it often precedes capitulation by the bank and devaluation of the currency.

However, the market’s main fear of the European crisis is centered on a disorderly breakup of the currency union, rather than on its crumbling economy. Even if the event were to consist only of the sudden exit of one of its smallest members, such as Greece, systemic seizure is still the beast to be feared.

The recession, a need for debt restructuring and the necessity of a choice between currency devaluation and prolonged competitive restructuring may appear to be the deeper problems – because in the long run, they are. But the financial crash of 2008 was not due to the recession underway at the time, though the latter may have been the underlying cause. It was set off by the disorderly bankruptcy of Lehman Brothers, just as the crash of 1998 (short-lived enough that few seem to remember it) was a long time in the making, but set off by Russia’s sudden default. The rot was always there, but so long as the structure stood traders could go about their business.

The big two-day rally received additional impetus Friday afternoon when stories of preparation for significant ECB intervention began to circulate: a package of another Long-Term Refinancing Operation (LTRO), rate cut, and buying of sovereign bonds by the ECB. As we go to press, bank president Mario is said to be enroute to Berlin to solicit the co-operation of Bundesbank (German central bank) president Jens Weidmann.

It was the kind of rally that infuriates bears wanting to talk about the data, such as decidedly mixed earnings news, with many companies reporting year-on-year revenue declines and beating earnings estimates via a combination of stock buybacks and accounting alchemy. Perhaps the best example was a near-8% rally in Amazon’s (AMZN) stock price on Friday despite results that missed on the top and bottom line, accompanied by a lowered outlook from management. The risk trade was back on again, and that was all that mattered.

The economic news was mixed, with the news out of Europe reflecting the deeply sinking economy. Both the German and EU manufacturing indices hit three-year lows. Indeed the latter may have spurred Draghi’s decision that the time was ripe to act – with the German data particularly weak, it may give the Bundesbank occasion to reconsider its opposition to further monetary accommodation.

Next week is a crucial one. Though markets may pull back briefly Monday morning in the absence of positive news from the ECB (or the presence of fresh German opposition), it shouldn’t last. The lure of month-end (Tuesday) and the central bank meetings (Wednesday and Thursday) are going to invite traders to test the May high of 1420 on the S&P 500.

If the S&P is sitting above 1400 on Wednesday morning – barely another percent higher from Friday’s close – it will require an amazing amount of temerity on the part of the Fed to launch a fresh package of additional accommodation. We hesitate to say impossible, because Fed chairman Ben Bernanke is capable of bold action, and it’s just possible that he and Draghi may feel that the only way to arrest the real downward slide in the global economy is with concerted action.

Yet it just seems too dangerous for us. Not only is there the political blowback to worry about, there is also the risk of having little firepower left should something unexpected come along. It seems more likely that any action will have to come from the ECB alone. The last round of its heavy fire helped markets to a spectacular first-quarter rally – but did not arrest the downward slide of European economies. We think it unlikely that markets will pause to consider that fact, however, at least not for some time.

That leaves the following conundrum – additional central bank intervention would cushion the decline in Europe, but not arrest it. Yet markets would likely put on another sustained rally anyway, because traders are loathe to be on the wrong side of liquidity and portfolio managers afraid to be left behind in the performance derby. And that, dear readers, is precisely the kind of combination that sets up markets for crashes – which only come from heights.

The Economic Beat

The economic news of the week was of course the GDP report. The odd thing about it was that it should have been a disappointment to trader hopes – neither weak enough to invite action from the Fed, nor strong enough to be a real positive surprise. The result of 1.5% (annualized) did best a lowered consensus estimate of 1.2%, but being that it had been 1.5% at the beginning of last week, one can hardly count it as much of a victory.

One item that pessimists were quick to fasten on – and rightly so – was the weak number in final sales, which slowed to 1.2%, the slowest such rate since the first quarter of 2011 (0.6%). Personal consumption slowed to 1.5%, the slowest rate in a year, and fixed non-residential investment slowed for the fourth quarter in a row. The latter was reflected in a weak report for new orders for durable goods in June, which unexpectedly fell by (-1.1%) excluding transportation. New orders for the business investment category fell (-1.4%).

However, over the years many a seemingly contrary data point has been feverishly embraced by a market that has the bit in its mouth, and the slowing final sales number did provide a kind of fantasy puzzle piece that could be joined in the clouds to the ECB and produce a dreamily big coordinated central bank move next week. Given the likely rise in stock prices going in, it’s hard to see how the dream can materialize.

The surprise of the report for us was the GDP price deflator, the number that adjusts GDP in current dollars for inflation. To begin with, we thought that the roughly 20% drop in oil prices might produce a low deflator reading, which would translate into a higher real GDP result. But the deflator value of 1.6% was exactly on consensus and in line with the latest price index figure (PCE) in the monthly personal income and spending report.

The bigger surprise for us number geeks was that the deflator for the fourth quarter of 2011 received a huge revision, from 0.8% (suspiciously low to begin with), all the way down to 0.1%. This pushed the fourth-quarter GDP result from 3.4% up to 4.1%.

Clearly, the BEA is doing something wrong with its deflator work. The 0.1% reading for Q4 of 2011 is bracketed by a third quarter reading of 3.0% and a 2.2% result for the following quarter. The PCE price index for the same quarter was 2.6%. It was also the lowest such reading since the fourth quarter of 2009 – the last time a reading greater than 4.0% was produced, and the two making up the only two quarters above even three percent in recent years. Given the size of the American economy, it is unlikely that either inflation or GDP are experiencing such abrupt up-and-down shifts in momentum.

Housing news was something of a disappointment during the week, with lower than expected results in both new home sales for June and pending sales for July. It echoed a familiar theme – the recent declines in personal spending, business spending, and now home sales all reflect the heightened anxiety on the part of consumer and investor.

Jobless claims were reported to have fallen substantially, from 388,000 to 353,000, but in unadjusted terms we have yet to see any departures from the pattern that has prevailed all year – actual claims continue to run about 10% lower than last year every week. There is some dispersion, but not much.

Like the rest of the data in recent months, the latest manufacturing figures were mixed. The new Markit “flash” estimate of the national purchasing manager index for manufacturing showed a positive reading of 51.8 that was slightly below estimate, but still positive, as was the result of the Kansas City Fed survey. The Richmond Fed survey plunged, however, and some of the Kansas City components were weak, with new orders negative and a sudden leveling off in production.

In theory, the event of the week next week is the FOMC statement on Wednesday. It may or may not be pre-empted or overshadowed by ECB action. The latter is scheduled to meet on Thursday, but traders will be chattering about the possibilities of surprise announcements and even better, coordinated intervention.

It will be a busy week for other data, and the Fed will get some important late results going into the meeting. The Dallas Fed reports its regional survey Monday, and the more important Chicago manufacturing and national manufacturing surveys come out on Tuesday and Wednesday. Consumer confidence also arrives on Tuesday, and is more likely to reflect the July slump in stock prices than last week’s rally. Personal income and spending – largely known from the GDP report – construction spending, and the ADP payroll report are the other data items that the Fed will have before it.

There is also the possibility that the committee will know something about the July jobs results that will be announced two days later, on Friday. Current consensus is for an increase of 100,000, and all we can say is that the guess-timate is likely to change between now and then. The ISM non-manufacturing index will come out 90 minutes later on the same day, but the markets will still be riding on whatever waves are produced by the central banks and the jobs report.